Summary

1.Financial instability: the bankruptcy of three US regional banks should not pose a systemic risk to the banking system. However, it has generated a massive wave of risk aversion.

2.Will central banks have to do more? The task of central banks has just become more complicated. The risk of financial instability has become apparent, the risk of recession has increased and the risk of inflation is still present. The market has revised its expectations of rate hikes from one extreme to another in our opinion. We expect the end of cycle rate to be 5.25% in May for the Fed and 3.50% (deposit rate) in June for the ECB.

3.Dramatic drop in interest rates: the movement seems exaggerated.

4.Short-term government bonds in the eurozone: we turned Positive on this sub-asset class at the end of February following the sharp rise in short-term rates (3.3% average yield for 1-3 year bonds).

5.Eurozone high yield corporate bonds: we are Neutral on high yield corporate bonds with a preference for the best rated sub-segment (BB). Carry is very attractive, but risks have increased. Better entry points could emerge in Q3-Q4 as credit spreads should widen when the effects of monetary policy are felt more. This will result in more dispersion within the asset class, lower credit ratings and higher defaults for the most fragile companies.

6.Strategically, there are opportunities in Fixed Income: we are Positive on US Treasuries and US IG corporate bonds. In the eurozone, we are Positive on short-dated government bonds and IG corporate bonds. We are also Positive on Emerging Market bonds, in hard and local currency. 

Central banks

Renewed doubts about the end-of-cycle rate

European Central Bank (ECB)

The economy is stronger than expected: inflation is picking up in several eurozone countries, business indicators are resilient, and the labour market is tight, pointing to wage pressures to come.

Erratic movements: the end-of-cycle rate expected by the market rose from 3.5% at the end of January to 4.2% at the beginning of March following better economic statistics before falling back to 3.4% after the bankruptcy of three US regional banks.

Our expectations: before these recent events, we had raised our end-of-cycle rate forecast to 3.5% in June (from 3.25% in May) following the rise in inflation. The risk of contagion in the eurozone seems limited, so the ECB should stay the course in its fight against inflation. We are still excluding rate cuts this year.

Balance sheet reduction: Quantitative Tightening began in March at a moderate pace. The pace beyond June is unknown and could therefore be a source of interest rate volatility.

US Federal Reserve (Fed)

Idiosyncratic risk: the bankruptcy of three US regional banks should not pose a systemic risk to the banking system. The Fed has already taken action.

Review 1: the process of disinflation in Q3-Q4 2022 was challenged with the improvement in January economic data. The Fed then considered the possibility of increasing the pace of rate hikes at the March FOMC meeting (50bp rather than 25).

Review 2: the bankruptcy of three US banks is changing the situation. The Fed must then strike the right balance between continuing to raise rates to combat persistent inflation and maintain the stability of the financial system.

Erratic movements: the market has revised its expectations of rate hikes from one extreme to another in our opinion, from more than 4 rate hikes expected this year to almost none.

Our expectations: we expect an end-of-cycle rate of 5.25% in May. We expect no rate cuts this year.

Investment Conclusion

The dominant market narrative changed 3 times in the space of one month. The Q3-Q4 2022 disinflation process gave way to the return of inflation risk in February, which gave way to the risk of destabilisation of the financial system following the bankruptcy of three US regional banks. The market has revised its expectations of rate hikes from one extreme to another in our opinion. We expect the end-of-cycle rates to be 5.25% in May for the Fed and 3.50% (deposit rate) in June for the ECB.

Bond yields

Massive moves

Flight-to-quality: the bankruptcy of three US regional banks has created a rush to safe-haven assets of (almost) unprecedented proportions. Short-term interest rates have plummeted. The movement is probably exaggerated and should partially reverse.

Positive view on short-term government bonds in the eurozone. The sharp rise in short-term rates in February paved the way for opportunities for investors wishing to park their cash without credit risk. The average yield on 1-3 year government bonds was 3.5% (3.3% at the time of writing, 14 March). The risk is that short-term rates will rise more, if inflation spirals, for example, which is not our scenario.

From a strategic point of view, we remain Positive on long-term US government bonds, although from a tactical point of view the US 10-year rate should rise after the exaggerated decline.

We remain Neutral on long-term German government bonds: the German 10-year rate should rise in the coming months. 

Investment Conclusion

The bankruptcy of three US regional banks has created a rush to safe-haven assets. The move is probably exaggerated and interest rates should rise again. We remain Neutral on long-term German government bonds and strategically Positive on long-term US government bonds. Our targets for 10-year yields are 3.5% in the US and 2.5% in Germany in 12 months. We turned Positive on short-term government bonds in the eurozone after the rise in short-term rates in February. 

Theme in Focus

High yield corporate bonds in the eurozone

Good start to the year: euro high yield corporate bonds have enjoyed a strong rally year-to-date        (+3.4% as at 8 March, +2.4% as at 13 March after the bankruptcy of the three US regional banks)  after a weak 2022 (-10.6%).

Reasons: the rally on the high yield segment on the back of a surprising economic improvement in January. The feared recession owing to the current energy crisis, has not materialised because the winter has not been cold. In addition, technical factors have helped, such as the thin new issuance volumes despite rising demand.

Valuation: credit spreads, which had narrowed to 400 basis points, were trading at 478bp on 13 March after the events in the US. They therefore have returned close to their long-term valuations after being expensive. Spreads could widen in the medium term as the risk of recession has increased in the United States.

Attractive carry: the average yield was close to 7.8% on 13 March, which seems very attractive on a historical basis.

Quantitative Tightening: the reduction of the ECB's balance sheet (Quantitative Tightening or QT) is a risk factor for high yield as it equates to a withdrawal of liquidity from the system. While QE (balance sheet expansion) triggered a wave of risky asset purchases, QT could create the opposite phenomenon, albeit on a smaller scale. It is estimated that the ECB will only reinvest half of all bonds maturing between March and June. This proportion could fall after June. Reduced demand,  lower liquidity and rising bond supply are all risks for Q3-Q4.

Default rate: in the context of rising refinancing rates and a likely slowing economy, companies' financial profiles will deteriorate and investors will be more vigilant about credit quality. This implies more dispersion in the asset class, more downgrades for weak companies and, over time, more defaults.

Favour the BB sub-segment: this sub-segment has underperformed recently and is still relatively cheap compared with other riskier sub-segments of high yield (see chart).

Investment Conclusion

We are Neutral on high yield corporate bonds with a preference for the best-rated sub-segment (BB). Carry is very attractive, but risks have increased. Better entry points could emerge in Q3-Q4 as credit spreads should widen when the effects of monetary policy are more visible in the economy (higher refinancing costs, lower liquidity, higher supply and lower demand). This will lead to greater dispersion within the asset class, credit rating downgrades, and a greater number of defaults among beleaguered companies.